The purpose of this paper is to analyze the European Commission's approach to state
aid for foreign direct investment in a competition policy framework. The Commission
shows to consider variable cost aid (VCA) to be more distortive than start-up or fixed
cost aid (FCA). This paper addresses that issue and checks whether allowing FCA while
banning VCA is a first-best strategy for a rational Authority maximizing welfare.
The model shows that a rational forward-looking government maximizing domestic
welfare always prefers VCA to FCA if both the incumbent and the entrant are foreign firms and if granting VCA does not cause to the incumbent firm to exit the market. On
the other hand, a VCA which causes the incumbent firm to be crowded out by the entrant
never occurs at the equilibrium.
The model shows that the Commission's approach may lead to sub-optimal equilibria
where market competition and consumers' welfare are not maximized.